Don't confuse accounting with causal relationships

By Scott Sumner

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Pierre Lemieux recently did a post explaining how people often misinterpret the GDP expenditure equation:

GDP = C + I + G + (X-M)

Many people, including even top trade officials in the Trump administration, wrongly assume that this equation demonstrates that imports subtract from GDP. That’s false, as the imported goods get added to C or I.

A commenter named Ahmed Fares makes a slightly more sophisticated argument:

If an American buys an American toaster for $40, US consumption, and by extension GDP, rises by $40. If an American buys a Chinese toaster for $40, US consumption rises by $40, which is then netted out of US GDP, leaving US GDP unchanged.

So that would mean imports have an indirect impact on GDP ($40 in this example).

Now I’m not forgetting that US imports put US dollars in the hands of foreigners, which can lead to US exports or a surplus on the US capital account, etc., but the first-order effects do seem to indicate that imports do have an indirect impact on GDP, which is what really matters.

In other words, the problem is not that imports caused US GDP to fall, when GDP actually remained the same, but rather that they didn’t allow US GDP to rise.

This common fallacy requires a bit more explanation. Let’s start with the assumption that the decision to consume a $40 toaster causes US GDP to rise by $40. Is that true? It may be, but it’s not a conclusion that in any way falls out of the accounting relationship. Recall that the national income accounting also implies that saving equal investment, at least ex post. So the decision to buy the $40 toaster also entails a decision to save $40 less than if one had not bought the toaster. If nothing else changes, then that reduces investment by $40.

Again, we are not yet considering macroeconomic factors such as the paradox of thrift or the relationship between saving and aggregate demand. We are still merely looking at accounting identities. And once again, the national income accounts show that, ex post, S = I.

One obvious counterargument is that the decision to buy a $40 imported toaster involves two negatives: less saving (implying less investment) and also the negative that is associated with imports in the national expenditure equation. There seems to be only one positive—a $40 rise in consumption. Does that save his argument?

Not quite, because we still have not worked through all of the accounting. There are actually two possibilities:

A. The foreign country takes the $40 spent on the imported toaster and buys US exports.

B. The foreign country runs a $40 larger current account surplus with the US.

In case A, there are two negatives and two positives. The first negative is that the decision to buy the imported toaster (instead of saving the money) reduces investment by $40. The second negative is that the imported toaster shows up as negative $40 in the trade balance. The two positives are the extra $40 in consumption and the extra $40 in exports.

In case B, there is one net negative and one net positive. The foreign country’s decision to run a trade surplus with the US causes US investment to be $40 higher than otherwise (for any given level of US saving.) This means that the normal decline in US investment that would occur when Americans reduce their saving does not occur, as foreign savings pour in to fill the gap. So the only negative is the $40 in imports, which shows up with a negative sign in the trade account. And of course the only positive is the $40 boost to consumption.

No matter what assumptions you make, the accounting relationships do not demonstrate any negative impact for imports.

What about if we look for broader macroeconomic causal factors, such as the paradox of thrift. Recall that this Keynesian idea suggests that an attempt to save more may end up simply reducing aggregate demand, thereby leading to no actual increase in realized saving or investment. Does that change the result? This turns out to be a very complex question:

1. If the Fed is targeting the money supply, then an attempt to save more may reduce V, and hence M*V (aggregated demand.) If the Fed is targeting interest rates, then when people try to save more the Fed will have to reduce the money supply in order to keep interest rates stable. Again, M*V falls.

More likely, the Fed is targeting something like inflation or NGDP. In that case, monetary policy offsets the impact of an increased propensity to save, leaving aggregate demand unchanged. So in practice, the issue that commenter Fares mentions is not much of a problem.

2. Now let’s assume that the Fed is not targeting inflation. Let’s say interest rates are stuck at zero and the Fed is allowing inflation to run below target, due to incompetence. Now it is at least possible that the decision to buy the foreign toaster will reduce aggregate demand. But even here the problem is not really trade, it’s saving.

Go back to the toaster example. There are two cases where AD might fall, and two where it would not:

Case A: If the seller of the toaster saves the $40, this tends to reduce AD. Importantly, this is true regardless of whether or not the toaster seller is domestic or foreign.

Case B: If the seller of the toaster doesn’t save the $40, then AD will not be reduced. A US seller would spend the money on some other goods, and the foreign seller of toasters would spend the money on US exports. (Here I’m looking at the aggregate behavior of the exporting country, not the decision of the individual seller.)

So any AD “problem” comes from too much saving, not the decision to buy imports rather than to buy local.

Bottom line, in order for the decision to buy the toaster to reduce US aggregate demand, you need both of the following to be true:

1. The foreign seller needs to be more likely to save the money than the domestic seller.

2. The central bank must respond passively, not targeting inflation or NGDP.

Even in the unlikely event that both conditions are met (and they are not currently met) you’ll still merely have impacted aggregate demand, not real GDP. To make the additional argument that this action would impact RGDP, you need a sticky wage/price AS/AD model. In that model, the short run AS curve is upward-sloping, and the long run curve is vertical. In that case, a trade deficit might possibly have a short run negative impact on GDP.

But the Trump administration officials making this argument are making a long run argument. They argue that the US has a secular problem of inadequate RGDP caused by trade deficits. This is one of those arguments that is false from almost every perspective imaginable:

1. The assumption about monetary policy is currently false. The Fed targets inflation at 2%.

2. AD has no long run effect on RGDP.

3. The empirical evidence also does not support the claim. The US and Australia have been running huge current account deficits, while the Eurozone and Japan have the world’s largest surpluses. And yet growth in US and Australian aggregate demand has been far more robust than in the Eurozone, and Japan has seen perhaps the most anemic growth in AD in the entire history of the modern world. There has been almost no increase in Japanese NGDP over the past 25 years.

Thus there is not one but two flaws in the theoretical underpinnings of the mercantilist argument, and on top of that the empirical evidence is completely inconsistent with their claims.

PS. One other question. President Trump says the condition of the US economy is now “great”. Things have never been better. If that’s true, then what is the purpose of launching a trade war right now? What problem is the trade war supposed to fix, even if we “win”?

READER COMMENTS

Don

Sep 7 2018 at 1:57pm

This is more complicated than it needs to be.

The accounting is clear: When I buy an imported $40 toaster, consumption increases by $40 and imports increase by $40, so no net change in GDP.

For most people, and particularly for most non-economists, the implicit counterfactual to buying a $40 imported toaster is buying a $40 domestically produced toaster. And in this counterfactual, GDP increases by $40. Thus, buying an imported toaster reduces GDP compared to the alternative of buying a domestically produced toaster.

Also, I’ll take a whack at the question in your postscript. I don’t think Trump wants to launch a trade war. I think he wants to threaten a trade war in order to obtain concessions from trade partners and improve the terms of current trade treaties. He may be mistaken, but it’s not an obviously foolish strategy.

Scott Sumner

Sep 7 2018 at 4:40pm

Don, That’s simply wrong, as I explained in this post. If there is a mistake in the post, tell me where it is. But don’t simply ignore it. All you’ve done is repeat Fares’s argument, which I demonstrated is false.

As far as improving the terms of our trade treaties, he’s already got a new one with Mexico, which is no better for the US than the old one. So there is reason to be skeptical.

Sebastian Roth

Sep 8 2018 at 9:44am

Taking this all in for me the question now is if there is parity in all political and economic factors of the 40$ being part of the U.S. Investment by being a foreign states trade surplus vs. being part of native U.S. savings/investment. People probably should then fight about that instead of the effect on the GDP which you show to be a strawman.

Also wouldn’t the acknowledgment that the spend 40$ are also 40$ less savings hold true in the case of the imported toaster too? I guess this doesn’t change the bigger picture though that there is no simple direct effect on the GDP in both cases (if I understood everything correctly).

Thaomas

Sep 8 2018 at 11:30am

Yes and no. It is the case that a consumer’s decision to purchase an imported bottle of wine rather than a domestically produced one has a first order effect of reducing GDP. Of course this can be offset by Fed policy that allows a change in the exchange rate that will maintain full employment.

Scott Sumner

Sep 8 2018 at 3:26pm

Sebastian, You asked:

“Also wouldn’t the acknowledgment that the spend 40$ are also 40$ less savings hold true in the case of the imported toaster too?”

Yes, but only if the foreign country spends that money on US exports. If not, then it becomes a current account surplus, which means there is no decline in saving available to fund US investment.

Thaomas, You said:

“It is the case that a consumer’s decision to purchase an imported bottle of wine rather than a domestically produced one has a first order effect of reducing GDP.”

No, that’s false. Again, the accounting relationships do not show that. More sophisticated macroeconomic factors such as the paradox of thrift might generate that causal effect, but they depend on global saving, not where the money is spent.

Todd Kreider

Sep 10 2018 at 10:59am

There has been almost no increase in Japanese NGDP over the past 25 years.

So why is this important? Japan’s RGDP growth has averaged about 0.8% a year since 2000 – the same as the U.S. In turn, the standard of living has increased by about the same amount since 2000.

Pierre Lemieux

Sep 10 2018 at 11:47pm

Interesting post, Scott! I had not seen it when I also replied to Ahmed Fares’s comment. My reply focused more on the idea that, as you say, “the accounting relationships do not demonstrate any negative impact for imports.” I also suggest that the accounting identity is consistent with the increase in GDP implied by the law of comparative advantage. The relation between accounting identities and theories is interesting.

Swimmy

Sep 11 2018 at 11:36am

“The implicit counterfactual to hiring a new employee is not hiring a new employee. Hiring a new employee reduces profits relative to the counterfactual of not hiring a new employee.” Nope.

“It is the case that a firm’s decision to hire an expensive employee rather than a cheap one has a first order effect of reducing profit.” Nope.

Hiring an employee increases costs, but it also increases revenue. You need some kind of theory or reason that the employee will increase costs more than increasing revenue.

Importing subtracts from C, but it also increases exports or savings, for the reasons detailed in this post. You need some kind of theory or reason that the import will subtract more from C than it adds to X or I.

Scott provided such a theory in this post, and explained why it’s implausible in most circumstances. Pierre offered a theory for imports increasing GDP in the long run.

Accounting identities can’t get you there alone. It really does need to be this complicated.

Todd Kreider

Sep 11 2018 at 12:16pm

This is a topic that I don’t see covered in econ texts either at the intro or intermediate level despite so many making the mistakes mentioned.

Mateusz Urban

Sep 18 2018 at 10:42pm

Couldn’t agree more. People are being taught those identities without really understanding what they imply (or even acknowledging the fact that they are identities, not equalities per se). You can easily graduate from grad school with Economics degree and do not undestand those (alleged) basics, and I am speaking from experience.

zeke5123

Sep 18 2018 at 12:31pm

Besides the factual question of whether the accounting is correct, isn’t there a more basic question regarding whether the accounting is measuring what we want it to measure (i.e., stand-in for wealth)? GDP is clearly used as a proxy for wealth, but that does not in fact make it wealth.

Tim C

Sep 18 2018 at 2:37pm

Interesting point about the S=I identity. I got a better understanding of this toaster problem by working it through from the top.

So let’s say in the beginning, the toaster was made and the American, lets call him Bob, makes $40.

Now, three things can happen:

A) Bob saves the money he made

B) Bob buys the toaster made in America

C) Bob buys the foreign toaster

The choices he makes has no impact on GDP at all.

If Bob does not buy the toaster and saves the $40, S increases by $40, and investments increases by $40 from the increase in inventory. So in total GDP increased by $80, which makes sense, since a toaster was produced, and the person produced $40 worth of value.

Now, if Bob decides to purchase the toaster with his savings. S and I both decrease by the same amount, preserving the S=I relationship, and C increases by the amount spent, so GDP remains the same, since the underlying production did not change.

If Bob decides to buy the toaster from foreigners though, C increases and S decreases by the same amount, however I does not change in this situation since the toaster would still go into Inventory because it unsold. GDP increased by an extra $40 over the situation in A, due to the inclusion of foreign production. IM offsets this extra GDP added in.

So at this time we have only one broken relationship, S is now smaller than I, and the two ways to fix this is outlined by Scott:

S increases through foreign savings such that S=I
That extra inventory is exported, so that I decreases and EX increases.

Therefore, it would be incorrect to think of GDP increasing by $40 when Bob purchases a toaster, as this is only a transfer between the different accounts, C, S and I. GDP remains constant regardless of Bob’s decision.

Warren Platts

Sep 19 2018 at 1:02pm

Tim, I think you made a math error. In the first case, Bob saves the money, but Alice made a toaster, so inventory (I) goes up by one $40 toaster. And that’s that. You’re double counting the toaster. S still equals I.

Tim C

Sep 21 2018 at 10:52am

If Alice is the one who made the toaster, she would have $40 of inventory. If Bob made $40 from a separate product, then his saving would be independent from Alice’s. If not, would you not be saying that if Bob worked for 5 hours at $8/hour to earn $40, say as a waiter at restaurant, and Alice produced a $40 toaster in inventory at the same time, that GDP only increased by $40? It’s pretty clear that $80 worth of goods and services was produced in this case.

Warren Platts

Sep 19 2018 at 12:39pm

>This is one of those arguments that is false from almost every perspective imaginable:

1. The assumption about monetary policy is currently false. The Fed targets inflation at 2%.

Isn’t “targeted” the operative word? One can target something, but that does not guarantee one will hit it. Interest rates are at historic lows near zero, and they can’t seem to hit their 2% target rate. It is not that the fed is incompetent or passive: it is just that the tools they have available are not effective. Thus, your two criteria above: (1) that foreigners are much more likely to save than Americans; and (2) the fed is not effectively managing for inflation, are both true, in which case we very well might expect the trade deficit to lower aggregate demand.

Stefano

Sep 19 2018 at 1:02pm

As I understand it, elementary economic theory assumes that GDP is dependent only on the quantity of capital and labor available, which the competition among firms assures are used in the most efficient way. GDP doesn’t depend on imports nor export, since import and exports don’t change the quantity of domestic capital and labor.

So if the domestic produced toasters are not liked by the customers, that means that our country has not the competitive advantage on toaster production, and the capital + labor of the toaster factories will be used to produce some other good for which we have a competitive advantage.

The problem is that in the real world, unlike the frictionless models of economics, retraining people to change jobs, and re-adapt plants to change product is very difficult, sometimes impossible. In these cases imports can cause a loss of income and wealth.

Dan

Sep 27 2018 at 10:19am

This was a good reminder of how focusing on imports/exports and GDP doesn’t tell you much, since there are so many moving parts in the background.

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